The current number one non-fiction best seller, Michael Lewis’ The Big Short: Inside the Doomsday Machine, addresses the question “Who got it right? Who saw the real estate market for the black hole it would become, and eventually made billions from that perception?” It is hailed as meeting the usual Lewis high standards of engaging story-telling and character depiction in combination with making a complex arena accessible to lay readers.

Lewis’ tale is neat, plausible to a mass market audience fed a steady diet of subprime markets stupidity and greed, and incomplete in critical ways that render his account fundamentally misleading. It’s almost too bad the book’s so readable, because a lot of people will mistake readability for accuracy, and it’s a pity that Lewis, being a brand name author, has been given a free pass by big-name media like 60 Minutes (old people) and The Daily Show (young people) to sell to an audience of tens of millions a version of the financial crisis that just won’t stand up – not if we’re really trying to get to the heart of the matter, rather than simply wishing to be entertained by breezy well-told stories that provide a bit of easy-to-digest instruction without challenging conventional wisdom.

The shortcomings of Lewis’ superficially pleasing work bear out the concerns of traditional reporters who were discomforted by the success of Truman Capote’s In Cold Blood: that turning a news report into a work of literature ran the risk of fitting facts to the Procrustean bed of a tidy, satisfying narrative.

The Big Short focuses on four clusters of subprime short sellers, all early to figure out this “greatest trade ever” and thus supposedly deserving of star treatment, bypassing the best known figure in this arena, John Paulson. The anchor is Steve Eisman, a blunt, unintentionally abrasive curmudgeon and money manager, who in his former life as an analyst put sell ratings on all the Gen One subprime lenders of the 1990s. Not only does most of the description of market chicanery and cluelessness come through him, but Eisman also serves as the main vehicle for depicting the shorts as noble opponents to a feckless industry.

Eisman’s realization that the industry he once covered, consumer finance, was out to “fuck the poor”, led a boyhood Republican to become, per Lewis, “Wall Street’s first socialist.” Eisman, plus his fellow colorful shorts, evoke comforting cultural cliches: Horatio Alger, Robin Hood, David v. Goliath (or as Eisman, would prefer to see it, Spiderman v. Carnage), Polonius’ “To thine own self be true” in modern garb, and of course, the classic Campbellian hero’s journey: a quest in the wilderness producing superior insight.

To make Lewis’ Manichean perspective stick, he has to omit vital facts that would lead to a more accurate, but complicated, less crowd-pleasing tale. Lewis repeatedly and incorrectly charges that no one on Wall Street, save his merry band of shorts, understood what was happening, because everyone blindly relied on ratings and failed to make their own assessment. By implication, the entire mortgage industry ignored the housing bubble and the frothiness of the subprime market. This is simply false (although with Bernanke and the persistently cheerleading US business media largely missing this story at the time, the “whocouldanode” defense is treated more seriously than it should be). Many people in the credit markets were aware that the risks were increasing in the subprime and residential real estate markets. Every mortgage industry conference during this period had panels on this topic, every credit committee considered it throughout 2005-07.

Lewis completely ignores the most vital player, the one who was on the other side of the subprime short bets. The notion that “it’s a CDO” is daunting enough to stop the non-financial reader in his tracks. The author is remarkably uncurious about who the end investors were for CDOs.

Listen up. Who really was on the other side of the shorts’ trades is the important question. And the section in which Lewis finally gets around to that (more than halfway thought the book, reader sympathies to his key actors now firmly established) hides the fundamental flaw in his narrative in plain sight:

…whenever Eisman sets out to explain the origins of the subprime crisis, he’d start with his dinner with Wing Chau [a CDO manager]. Only now did he fully appreciate the central importance of the so-called mezzanine CDO – the CDO composed mainly of BBB rated subprime mortgage bonds – and its synthetic component, the CDO composed entirely of credit default swaps on triple-B rated subprime mortgage bonds. “You have to understand this,” he says. “This was the engine of doom.”…

All by himself, Chau generated vast demand for the riskiest slices of subprime mortgage bonds. This demand had led inevitably to the supply of new home loans, as material for the bonds.

Yves here. It wasn’t all by himself, as we will see soon:

….the sorts of investors who handed money to Wing Chau, and thus bought the triple A rated traches of CDOs – German banks, Taiwanese insurance companies, Japanese farmer’s unions, European pension funds, and in general, entities more or less required to invest in AAA rated bonds -did precisely so because they were supposed to be foolproof, impervious to losses, and unnecessary to monitor of think about very much.

Yves again. Note that these are the international equivalent of widows and orphans, but because they are exotic, presumably elicit less sympathy. But as we will discuss soon, by this point in the tale, January 2007, that list of prototypical chumps was out of date, which has further implications for the real significance of this trade.

Starting in mid-2005, when the creation of a standardized credit default swap on mortgages made it feasible to take large subprime short positions, a system quickly developed that overrode the normal checks and balances of the market and allowed the unscrupulous to 1. Profit from making bad loans, and 2. Force the creation of more bad loans, which would both increase their profits and make it more likely that their bet would be successful.

Most mortgage industry participants assumed there was a degree of rationality that would constrain reckless behavior. And this belief was not as naïve as it seems now. Past lending excesses, such as the late 1980s LBO craze, even the savings and loan crisis, had died under their own weight. The 1990s subprime boom ended precisely because investors started to shun the risky slices of CDOs, which made selling subprime bonds unattractive (CDOs had been a necessary outlet for selling less desired tranches of subprime bonds), which choked off demand for subprime loans.

A critical element of how this new system operated was by sending false signals to market participants. Imagine you are a doctor. You have a well established patient with a known heart problem and high cholesterol. He comes to his regular checkup looking simply wretched, with bad color, low energy, and complains of not feeling well. You immediately run all of your regular (thorough) tests, plus some additional ones related to his new symptoms. Yet all the results come back within normal bounds, save his known problems, and there you see no meaningful change from his previous history. You ask him to come in quarterly, rather than annually. He continues to look even worse, yet his test results continue to show nothing more amiss than before he started to look so awful. He drops dead of massive coronary blockage.

Now in our little fable, what happened was that someone saw the patient on the street and recognized he was a prime candidate for heart failure. He takes out ten life insurance policies on the patient and finds a way to alter the test results so everything looked normal. The doctor, conditioned to trust the tests, believes them rather than his lyin’ eyes, and fails to take action.

Tom Adams, who has spent his career in the mortgage business, and was an executive at one of the major monoline insurers during the subprime mania, explains:

Starting in 2005, following the introduction of credit defaults swaps on mortgages, the spread for lending to risky borrowers fell. Normally, when risk becomes mispriced like this, the right approach is to step back and wait for sanity to return. And many cash investors did just that.

The problem this time was the market didn’t correct.

By 2006, many companies in the risk business received pressure, in one form or another (investors, rating agencies, etc.), about how they were missing out on revenue opportunities. The market was booming, yet they were on the sidelines. No one I encountered wanted to take subprime mortgage risk (or Alt A mortgage) risk directly because the risks were considered too high and the premiums were way too low.

In a normal environment, this should have led to the mortgage market grinding to a halt – since no one wanted the BBB portions of any subprime or Alt A deal. Hundreds of people at conferences, in meetings and over the phone lines argued that the market for subprime was acting irrationally. Refusing to participate in the market at all would, in retrospect, have been the only solution, but this is easier said than done. A lot of people were told: “You’re the expert in this area, find a way to make money in it – everyone else is.”

How did this happen? By 2005, “cash” or traditional investors, were leery of subprime risk. Yet the interaction of increasingly synthetic CDO issuance, credit default swap spreads, and the resulting artificially low yields on BBB subprime bonds sent a powerful signal that the subprime patient was somehow still healthy. Presumably, a lot of someones were highly confident they could find gold within what looked to most like certain subprime dreck.

Back to Lewis:

The whole point of the CDO was to launder a lot of subprime mortgage market risk that the firms had been unable to place straightforwardly…..

“He ‘managed’ the CDOs,” said Eisman, “but he managed what? …. I thought, ‘You prick, you don’t give a fuck about the investors in this thing.…

“Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ ”

Say that again.

“He says to me, ‘The more excited that you get that you are right, the more trades you’ll do, and the more trades you do, the more product for me.”…

That is when Steve Eisman finally understood the madness of the machine… There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets to synthesize more of them… “They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than the just the subprime loans. That’s when I realized they needed us to keep the machine running.”

Yves again. So what does Eisman do, our hero, vocal advocate of the poor and exploited, who now (along with Lewis) indisputably knows that he is an integral part of the problem?

“Whatever that guy is buying, I want to short it.” Lippman took it as a joke, but Eisman was completely serious. “Greg, I want to short his paper. Sight unseen.”

Eisman recognizes that the subprime market is a disaster waiting to happen, a monstrous fire hazard that, once lit, will engulf the housing market and financial firms. Yet he continues to throw Molotov cocktails at it. Eisman is no noble outsider. He is a willing, knowing co-conspirator. Even worse, he and the other shorts Lewis lionizes didn’t simply set off the global debt conflagration, they made the severity of the crisis vastly worse.

So it wasn’t just that these speculators were harmful, and Lewis gave them a free pass. He failed to clue in his readers that the actions of his chosen heroes drove the demand for the worst sort of mortgages and turned what would otherwise have been a “contained” problem into a systemic crisis.

The subprime market would have died a much earlier, much less costly death absent the actions of the men Lewis celebrates. They didn’t simply keep the market going well past its sell-by date, they were the moving force behind otherwise inexplicable, superheated demand for the very worst sort of mortgages. His “heroes” were aggressively trying to find toxic waste to wager against. But unlike short positions in heavily-regulated equity markets, these wagers, the credit default swaps, had real economy effects. The use of CDOs masked the nature of their wagers and brought unwitting BBB protection sellers to the table, which lowered CDS spreads (and as in corporate bond markets, CDS dictate, via arbitrage, interest rates for bond issues) and pushed down the interest rates on the cash bonds backed by those same loans, which in turn made it perversely attractive for lenders to generate mortgages with the worst characteristics. And it isn’t surprising that weak-credit borrowers were enticed by this once in a lifetime “opportunity”.

Lewis misses an even more stunning part of this picture. His colorful band, although engaged in damaging conduct, were comparatively small fry, beneficiaries of the strategies of even more clever and lethal actors. Chapter 9 of ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism discusses how a single hedge fund, Magnetar, which has heretofore been missed in every major account of the subprime crisis, was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006. Apparently unbeknowst to Lewis, his shorts were riding the slipstream of Magnetar’s trade, with a significant percentage of their credit default swaps coming from its and its imitators’ CDOs.

And who stepped in on the other side of these short bets? Who were the investors in the CDOs? For the riskier slices of the CDO, it was a bizarre combination: chumps, almost entirely foreign, and supposedly sophisticated correlation traders, (Lewis discusses one at length, Howie Hubler of Morgan Stanley). Across the board, they suffered spectacular losses.

But as Lewis stresses, the ruse at the heart of this great trade was that the shorts were betting against BBB subprime trash, which when packaged into CDOs, had roughly 80% rated AAA. So who were the fools taking toxic BBB risk for mere AAA returns?

For the most part, the dealers themselves. Without going into mind-numbing detail, the apparent risklessness of an AAA instrument hedged by an AAA counterparty (in this case, a monoline) substantially reduced the capital a dealer needed to support a position. As a result, holding AAA CDOs hedged by AAA guarantors was treated, on a profit and loss basis on the relevant dealing desks, as vastly more attractive than finding investors to take the other side of the trade. In other words, this was massive gaming of the banks’ own bonus systems.

So what was the dealers’ big mistake? When the subprime market started hemorrhaging losses, the Magnetars and the smaller subprime shorts wanted to be paid on their successful bets. For the AAA investors, that meant ponying up cash. They went to the monolines, only to be rebuffed. Even though the insurers would likely have to pay out on their subprime guarantees, the provisions of their contracts assured would be a VERY long time, often decades, before their check would be in the mail. So the dealers themselves, due to their own poor incentives and inattention, were faced with unexpected losses and caught in a liquidity crisis. They suddenly had to cough up lots of money to Lewis’ supposed heroes. Wall Street took multiple hits: writedowns, downgrades, and a cash drain when funding was increasingly scarce.

So who was ultimately on the other side of these lionized trades? When Wall Street could no longer pay the Magnetars, the biggest chump of all, taxpayers in the US and abroad stepped into the breach. We are the ones bearing the enormous cost of state sponsored bailouts and real economy damage, the wreckage this “greatest trade ever” hath wrought.

Lewis’ need to anchor his tale in personalities results in a skewed misreading of the subprime crisis and why and how it got as bad as it did. The group of short sellers he celebrates were minor-leaguers compared to the likes of Goldman Sachs, Deutsche Bank and John Paulson. But no one on the short side of these trades, large or small, should be seen as any kind of a stalwart hero and defender of capitalism. Circumstances converged to create a perfect storm of folly on the buy side, beginning with essentially fraudulent mortgage originations at ground level, which the short-sellers – whether trading at the multimillion or multibillion dollars level – took advantage of. That they walked away with large profits may be enviable, but there was nothing valiant about it. In the end, Main Street, having been desolated by a mortgage-driven housing bust, now found itself the buyer of last resort of Wall Street’s garbage.

Lewis’ desire to satisfy his fan base’s craving for good guys led him to miss the most important story of our age: how a small number of operators used a nexus of astonishing leverage and camouflaged risk to bring the world financial system to its knees and miraculously walked away with their winnings. These players are not the ugly ducklings of Lewis’ fairy tale; they are merely ugly. Whether for his own profit or by accident, Lewis has denied the public the truth.

149 comments

I heard Mr. Lewis being interviewed on NPR about the subject of his book and he said something so outlandish as to tarnish his reputation, at least with me. He essentially asserted that indicting and convicting any of the miscreants involved in the sub-prime disasters would be a waste of time. As evidence, he cited the S&L scandal in which a substantial number of the malefactors were tried and convicted for their roles in the debacle.

Mr. Lewis’ comment about those convictions was, “What good did that do.” As if the fact that since the conviction and incarceration of people for the S&L crimes did not prevent the sub-prime crimes was evidence that meting out justice was pointless. It was a stupefying bit of logic since it follows from such “reasoning” that many, if not most crimes should go unpunished since doing so would not guarantee that the exact same crimes would not be committed by someone else in future. This man has absolutely no understanding of the primary purpose of the criminal justice system

It seems to me this is a matter of perspective, not that your POV isn’t accurate. Markets require both buyer and seller. In a zero-sum game, presumably, each side of a trade thinks the other a sucker. Those providing “insurance” believed they’d never have to pay. Those buying insurance couldn’t believe someone sold it to them in the first place. Had the sellers been able to “kite” the scheme long enough, the shorts may well have been spectacular losers as their bets collapsed under the burden of negative carry. Regardless, I fail to see how Paulson, Eisman, Magnetar, and other “winners” are the villains here. They simply saw an inefficiency and exploited it. From where I sit, the real villains seem to include rating agencies, regulators, governments, investment banks, mortgage lenders, borrowers, and others.

You are missing a critical point. There was at least two significant departures from your “willing buyer/willing seller” model.

For that model to produce socially desirable outcomes, the buyer and seller have to have equal access to relevant information. They didn’t. As discusses longer from in the post, the action of the shorts was creating a massive, self-reinforcing market distortion. It was a different set of structures, but the use of trusts (and trust of trust and trust of trust of trusts) in the 1920s played a major role in the stock market crash (in fact, Frank Partnoy, in a recent presentation, shows that some of the 1920s structures were exact parallels to CDOs).

The reason shorting is not a purely destructive activity in the equity markets, and is seen to be useful, is that its abuses are curtailed by strict regulation. By contrast, there are no cops in CDS/CDO land.

You are also incorrect in your assumption that the monolines expected never to pay out claims. This was not an “AIG free money” situation. Admittedly, one monoline in particular is universally seen as hopelessly stupid, but the monolines went to considerable length both to evaluate the deals on a number of fronts, and structures their contracts completely differently than AIG’s, to severely limit when they would be obligated to pay out, and more important, to delay it substantially even when they were obligated to pay. What killed them was not cash losses, but mark to market losses.

Most important, you missed the significance of Tom Adam’s throwaway remark re pressure from rating agencies. How could a rating agency pressure a monoline? Monolines depended on AAA ratings. The rating agencies could withdraw it, so they held the power of life or death over the monolines.

The ratings agencies threatened to downgrade the monolines if they didn’t have sufficiently “diversified” earnings. That meant a reasonable participation in the structured credit business. Recall the rating agency economics. Their structured credit, particularly CDO, rating business, was their big money machine, far more profitable than their bread and butter business of rating corporate and municipal bonds. The critical pieces to getting a CDO launched were having an equity investor (Lewis muffs this in his book, the Wing Chaus were not equity investors, but took some of their consideration in the form of a piece of the equity, it was Magnetar-types who were equity funders) and a monoline.

So the rating agencies were putting huge, and real, pressure on the monolines to keep insuring CDOs.

This hardly fits the textbook fairy tale of willing buyers and willing sellers.

Yves, you miss the forest for the trees here. The villains were the legislators and regulators who enabled the CDS market, with their idiotic capital rules, their refusal to deal with financial statement chicanery, their determination to put every American in a house he could never afford. Those offering insurance to the shorts were not widows and orphans; they were those entrusted with the savings of widows and orphans, who never should have been permitted to write insurance on CDOs and for the most part failed to understand they were doing it. You seem to have this blind spot about shorts. Without shorts you have no market. The problem here is toxic products. They poisoned the entire financial landscape, denied capital a fair return, enriched a coterie of looters on the inside, and remain every bit as entrenched as they ever were.

The stuff you wanted covered (“The villains were the legislators and regulators who enabled the CDS market, with their idiotic capital rules, their refusal to deal with financial statement chicanery” etc etc) is in ECONNed.

This is just a blog post, so it deals with a piece of the picture, not the whole thing.

I think that “without shorts, you have no market” was Yves’ point: without shorts, you would have had no market for synthetic subprime after cash borrowing and lending stopped. And we would have been better off. There never SHOULD have been a market.

This sounds like too much of a conspiracy to me. Ratings agencies threatened monolines with downgrades if they didn’t insure more CDOs? C’mon now. First of all this is completely illegal. Second of all, what’s in it for the ratings agency? How do they benefit if monolines show growth? They weren’t the ones creating CDOs, the banks were. Also didn’t a lot of hedge funds sell CDS? (And Lehman Brothers? Hello!)

It was not explicit. But the ratings agencies clearly told the monolines they needed to have diversified earnings, which would force them to have a meaningful position in the structured credit business (ie, withdrawing or cutting back significantly would be treated as a negative). This is pretty well recognized among people in the business, see:

Just wanted your opinion on this article I found that woke me up hoping that it was not real. If people find out that their “Gold Certificates” (paper proof) are completely worthless (thanks to the likes of Morgan Stanley and others who have sold these certificates for 100x more than the gold they actually possess and charged storage fees for precious metals they don’t have) what would happen to the markets if the bank customers want physical possession of their gold only to find out that they barely have any gold in their vaults period. Below is a brief paragraph along with a link to the audio interview, it is quite stunning to listen to.

“Continuing on the trail of exposing what is rapidly becoming one of the largest frauds in commodity markets history is the most recent interview by Eric King with GATA’s Adrian Douglas, Harvey Orgen (who recently testified before the CFTC hearing) and his son, Lenny, in which the two discuss their visit to the only bullion bank vault in Canada, that of ScotiaMocatta, located at 40 King Street West in Toronto, and find the vault is practically empty. This is a relevant segue to a class action lawsuit filed against Morgan Stanley, which was settled out of court, in which it was alleged that Morgan Stanley told clients it was selling them precious metals that they would own in full and that the company would store, yet even despite charging storage fees was not in actual possession of the bullion.”

To me neither of these seem plausible as anything more than interesting side-shows. I dont know how much you think Magnetar made, but Paulson reputedly made $15B which is a lot for one guy put chump change in the context of the overall cost of the crisis.
Also if the CDOs etc were so important how come other countries like UK, Spain, Ireland and Iceland had very similar bubbles which collapsed at the same time as the US did (or only months before).

You need to read my book. I lay out the analysis in considerable detail. These structures were massively leveraged.

Every $1 in mezz CDO equity that funded cash bond purchases in the CDO (meaning the BBB tranches) generated $533 in subprime bond demand. The math is set out in detail and was reviewed by CDO market participants, people on the desks at dealers who actually put these deals together. People in the market who have read the book (as in were not involved pre-publication) confirm our analysis.

Let me put it another way: I was told, by multiple sources, that Magnetar drove 50% to 75% of subprime bond demand in 2006-2007. The analysis in the book is simply to demonstrate why this view is plausible.

Paulson was using mainly ABX shorts, he was not a meaningful generator of subprime demand. It was the funders of CDO equity (and per an earlier comment Wing Chau was not an equity funder).

The difference is Spain etc. did not have a systemic crisis that almost destroyed the world financial system. Banks routinely run off the cliff together, they screw themselves up on a regular basis, but the amount of damage done thanks to the subprime shortrs was greatly disproportionate to the amount of actual subprime loans. S&P says that for every dollar of BBB subprime bond, an average of $10 of CDS were written. And remember, among those already likely to be crappy bonds, the shorts were working hard to find the worst of already weak paper.

I sincerely apologize for previous comments. Your completely honest take on this reinstalls my hope for humanity.

You are exactly correct. And, my own personal comment on this matter. to anyone who has studied this situation will comprehend the following: upon the closest examination, leveraged buyouts, hedge funds and securitizations and securitized financial instruments (CDOs, CDS, CLO, CFO, CPDO, crises derivatives, Pinnacle Notes, ad infinitum) all all fundamentally the same financial constructs.

It sounds like in the end this is still trying to propagate the same lies that (1) whoever “makes money” should be celebrated as some kind of hero, (2) in particular, finance parasites are heroes, while the finance sector existentially is good or at least a law of nature not to be questioned. Somehow because these parasites were metaparasites on the direct parasites is supposed to make them “good guys”, in this pernicious construction.

While I haven’t read this book, I did read Lewis’ piece on AIGFP where his thesis basically was that Cassano was a “bad apple”. It sounds like this is more of the same – bad apples and a few heroic good guys, while the criminal structure itself is exonerated.

Lewis is like an apologist who would write a history of slavery in America, with his heroes being not abolitionists (on the contrary, he’d say they’re wrong), but slavers who treated their chattel relatively well.

“It sounds like in the end this is still trying to propagate the same lies that (1) whoever “makes money” should be celebrated as some kind of hero….”

Exactly. Lewis is still the kind of guy who likes to breathlessly drop how he is able to hitch a ride in the private plane of a billionaire friend. He thinks that kind of thing gives him credibility, but it’s the reverse.

None of them seemed to understand that when you create a derivative you don’t add to the sum of total risk in the financial world; you merely create a means for redistributing that risk. They have no evidence that financial risk is being redistributed in ways we should all worry about.

The fact that he’s being lionized on e.g. 60 Minutes is laughable. And I completely agree with Yves about the debilitating effect of having a personality-driven narrative.

In reply to a later poster I postulated that Lewis was intelligent enough to do entertainment and insightful analysis at the same time. Your Davos link changed my mind. His intelligence doesn’t extend much beyond conventional ‘wisdom.’

The U.S. financial system is tilted in favor of the biggest banks, compromising the “very foundation of the economic system” and putting the nation at risk of continued crises, a top Federal Reserve official said Wednesday.

Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City and the current longest-serving regional Fed chief, has been an outspoken advocate on behalf of community and regional banks. Megabanks, he’s long argued, benefit from the kinds of implicit and explicit government guarantees that hurt their smaller competitors, distorting the market and crippling Main Street.

“If we stray from our core principles of fairness or ignore the rule of law, we distort the playing field and inevitably cultivate a crisis,” Hoenig said during a speech at a U.S. Chamber of Commerce summit in Washington. “When the markets are no longer competitive, firms become a monopoly or an oligopoly and it matters more who you know than what you know. Then, the economy loses its ability to innovate and succeed. When the market perceives an unfair advantage of some over others, the very foundation of the economic system is compromised.

“The protected will act as if they are protected, they will retain their status independent of performance, and the public will suffer.

“As a nation, we have violated the central tenants of any successful system,” Hoenig said. “We have seen the formation of a powerful group of financial firms. We have inadvertently granted them implied guarantees and favors, and we have suffered the consequences. We must correct these violations. We must reinvigorate fair competition within our system in a culture of business ethics that operates under the rule of law.”

I saw Lewis on a couple shows during his book tour. He smiled a lot and told interesting stories about the characters he found. But it seemed pretty clear that he didn’t have a grasp of the whole picture.

At the time I was reading “Econned”. That is the best book I have found on the subject thus far. It put most of the story in context for me, finally. The description of the setup bad choices our society has been making rang true to me too.

I’d love to see Yves get a chance to do similar book interviews. I sent a couple emails to the Rachel Maddow show. It would be really nice to see Yves there or John Stuart, or pretty much any show with a literate audience.

Yves, your writing is very clear, but your powerful brain and enormous vocabulary, sometimes leaves us mere mortals behind. Hagiography — I had to look that one up.

Thank you Yves, for your as usual clear-headed and valuable analysis of
the new Lewis hagiography. All the big bestsellers on the crisis, including Paulson’s and Sorkin’s, are just trying to paint out, or to paint over, the real and very visible culprits of this severe crisis, the big Wall Street players, including Deutsche Bank and UBS in Europe.

I agree that Lewis (in a brilliantly written book) does not see the whole picture and you lay it out in your Chapter about Magnetar.

What I do not get is why Eisman & Co should have done something morally reprehensible. They did not buy the equity layer while shorting mezzanine as Magnetar did. Eisman was shorting what Germans were buying and AIG was guaranteeing – where did he drive the buying and guaranteeing ?

Can you elaborate on that sentence: “these wagers, using credit default swaps, had real economy effects. They pushed down the interest rates on the cash bonds backed by those same loans, which in turn made it perversely attractive for lenders to generate mortgages with the worst characteristics.”

I do not understand that sentence.
Wasn´t Eisman on the side of the swap providing supply and thereby driving rates higher ?

The reason the trade was attractive to the shorts was that it was grossly mispriced via the use of heavily synthetic CDOs. With 80% of the CDO fetching AAA yields, the shorts were exploiting a massive mispricing.

Burry (one of the four players described in the book) didn’t have the vantage to see the role of the CDO. Cornwall Capital did set out to short CDOs directly, but appears not to have understood the systemic consequences. So even though what they did was destructive, they were not knowingly destructive. Indeed, Cornwall tried notifying the SEC as they came to understand the market better. Eisman is different, he understood who was bearing the ultimate risk and that the short were distorting the mortgage market, yet chose to incorrectly personalize it in the CDO manager, Wing Chau, apparently to rationalize his behavior as he continued to pile into the trade.

The CDOs would not have existed without the shorts, and the trade continued because you had many actors making decisions based on trading games where the quality of the CDO was utterly irrelevant. So the normal checks on credit quality were suborned. And given how favorably you could repo AAA CDOs (only 2-4% haircuts), they could attain further leverage.

The correlation traders only cared re pricing differentials between tranches, so credit risk was not a consideration. A high % of the AAA tranche buyers were gaming their firm’s bonus systems, so they didn’t care re credit quality. And you had Merrill, which had a mandate from top management to defend their leading position in CDOs, which meant they were doing every CDO they could get their hands on and were indifferent to the unsold AAA inventory on their balance sheet (with Merrill, the driver of all the CDOs they held may have been more pipeline than negative basis trade, although I am todl the negative basis trade was pervasive). Even though the “inner” meaning lower CDO tranches were a nuisance to place, between correlation traders, foreign chumps, and rolling them into other CDOs, they could be disposed of.

So there were few constraints on the demand side for rated CDO tranches. The constraints were the supply (the cash bonds and the CDS) and the equity tranche. That’s why the spreads stayed so low for so long. Once Magnetar and its imitators figured out the trade, they would pump out a ton of CDOs every time their trade parameters fell into place. Magnetar was even able to squeeze the dealers on fees.

I would appreciate it if you would elaborate on this point as well. I’m especially confused by the following:

In a normal environment, this should have led to the mortgage market grinding to a halt – since no one wanted the BBB portions of any subprime or Alt A deal. Hundreds of people at conferences, in meetings and over the phone lines argued that the market for subprime was acting irrationally. Refusing to participate in the market at all would, in retrospect, have been the only solution, but this is easier said than done. A lot of people were told: “You’re the expert in this area, find a way to make money in it – everyone else is.”

…

How did this happen? By 2005, “cash” or traditional investors, were leery of subprime risk. Yet the interaction of increasingly synthetic CDO issuance, credit default swap spreads, and the resulting artificially low yields on BBB subprime bonds sent a powerful signal that the subprime patient was somehow still healthy.

In the first paragraph, you seem to say that market participants found yields on BBB bonds too low to justify buying (in retrospect, clearly the right interpretation). Yet, in the second paragraph, low yields are supposed to have been a signal that the market was healthy, and that one should continue to buy. So which was the real perspective adopted by market participants?

I submit that it was the latter. It still looks to me like a whole lot of these so-called “widows and orphans” went stretching for an extra 50 bps of yield and got burned. If there was an asymmetry of information, it probably had a lot to do (as it does in almost every mania) with the sort of information they thought was worth paying attention to. Plenty of people were warning about the conflicts of interest at the rating agencies, and Jim Grant wrote several articles highlighting the perversity of the synethic CDO structures. The credit bulls ignored these warnings because at a deep level they wanted to follow the herd and keep buying.

To the extent that a lot of these shorts have only been paid off because the dealer banks which took the other side of their bets were ultimately bailout out by taxpayers, then no, they don’t deserve a lot of praise or admiration. But, even in that case, I would think the harshest condemnation should be reserved for the people who created that moral hazard in the first place, primarily the advocates and architects of public bailouts of private institutions. They’re the real Molotov cocktail throwers.

Savvier AAA investors had already gotten nervous re AAA CDOs as of 2005, the structures were having to get more and more aggressive to product the yields. Gillian Tett was writing frequently about it in the FT.

It is a near certainty that Lewis’ claims re who the AAA “funders” were was exaggerated.

These heavily/entirely synthetic CDOs did not have “cash” investors for the top tranches. The dealer put up a VFN (variable rate funding note) for the top tranche and would often in turn sell CDS against that to rip out more fees (the dealer could also have investors be the VFN funder). I am told that the parties that were willing to go this route were mainly in the Middle East. Another big one was IKB. My sources tell me the German government (which rescued IKB) is preparing to litigate, they think major misrepresentations were made. There have also been occasional stories re hedge funds being AAA funders, but I have doubts this happened all that much ex correlation traders (as in they were long the AAA but short a lower-rated tranche). There would have been many more reports of hedge funds deaths or impairment from this trade if it had been widespread.

The overwhelming majority of “widow and orphan” AAA investor were prohibited by regulations or otherwise reluctant to use CDS to create a synthetic AAA position.

You are also ignoring the pressure on mortgage market participants. If you have overhead, and you are supposed to be in a certain line of business, most companies do not find it acceptable to do nothing for three years. A non Freddie/Fannie mortgage related player would have had to go to the sidelines in 2004 to be fully in the clear. The ONLY person I know of who is willing to let his staff do nothing and collect salaries waiting for opportunities is Warren Buffett in his reinsurance business under Ajit Jain.

So what do you do? Say no and be fired? And your only skills are in that business, if you get a job somewhere else you will be subject to the same pressures to participate in the stupidity. If you are over 30, changing careers is hard.

You miss the fact that a fair number of people did the problems and yet had institutional imperatives they could not buck.

If you have overhead, and you are supposed to be in a certain line of business, most companies do not find it acceptable to do nothing for three years.

…

You miss the fact that a fair number of people did the problems and yet had institutional imperatives they could not buck.

This is also an excuse that is routinely employed by fund managers who buy stocks at mania tops like Dow 14,000. “If I don’t participate in the bull market, my investors will get restless and go somewhere else!” This institutional imperative is one that recurs at every bull market peak, but I haven’t yet seen any workable solution for it. The best we can do, I think, is to make sure that those who follow this “imperative” suffer the full weight of the losses that it visits upon them, as a warning to future mania participants who are tempted to take leave of their reason in order to join the investing herd.

I definitely don’t see how the existence of such an imperative somehow makes it unfair or illegitimate to bet against the market mispricings that it creates. I agree that one should sound the alarm while placing the bet, but even then, I’m not entirely convinced one is morally obligated to do so.

Over the long run following this imperative proves to be a poor strategy both for both personal performance and job security — in the most extreme cases, the ones who knew their firms were taking undue risk, and yet said or did nothing, lost their jobs when their firm went bankrupt.

I disagree that the best we can do is “make sure that those who follow this ‘imperative’ suffer the full weight of the losses that it visits upon them”.

The herd is a herd of intermediaries. They don’t take the losses. The losses are visited on those whose savings the herd is “managing” (i.e., getting rich on parking fees and a massive ratio of AUM to people, getting filthy rich the years they actually make money gambling with what’s left).

Short of laws that truly align investor and money manager interests, I think the best we can do is discipline these people by taking our money away from them.

These people are not money managers, they are for the most part in much larger organizations with much less control over decisions than money managers.

And you seem unable to think through the choices. If you quit, you either have to go somewhere else in the industry and be expected to participate in the same nonsense (as in you have not escaped the dilemma you were trying to avoid) or move to another field, which usually entails large pay cuts, even assuming you can find a job.

So the punishment is visited on those who object, not those who participate.

And it’s particularly easy to moralize if you don’t have a family to support.

Your analysis wrongly puts all the blame on the shorts, who had no legal (and you try to imply a moral) duty whatsoever to the investors on the long side of the trade, and you put no responsibility at all on the broker-dealers who structured, funded (other than synthetic) and actively marketed CDOs to idiot long investors. The big broker-dealers made tons of money on the spread between long and short where they were an intermediary, where they went short (like Goldman) they made even more money on that, and where they tried to go long either by holding the crappy securities they themselves made (not knowing they were crap) or by buying other people’s crappy securities on the market (which happened a lot as well, with lots of buying power from leverage — e.g. Bear, Lehman, Merrill, etc.), they hoped to make a lot but got creamed in the end.

As between the shark (the party that sees problems in a trade and takes the shrewd side of it) and the dupe (the party that doesn’t see the problems and gets creamed) you consistently take the side of the dupe. That’s OK as a natural proclivity, we all have our sympathies, but sometimes we want to favor each for good reasons. We like sharks because we want people to do their homework and make money by being smart, and we hate dupes because we want people to suffer the natural economic consequences of not doing their homework. On the other hand, we don’t like sharks where they cross the rules of fair play, and we like dupes enough to protect them from being wrongfully taken advantage of.

On the shorts, you fail to say what was “wrong”, trying to imply some moral duty where there is no legal duty, privity of contract (shorts typically didn’t deal directly with longs, always through broker-dealers) or even knowledge of who exactly was net on the other side of a trade. However, you are silent or at least dramatically quieter on the broker-dealers, whose very label states their conflict of interest (are they a broker or a dealer? are they dealing for their own book or are they a customer’s agent?), who SOLD the deals to the long investors with greed, ignorance or both. What is the duty of a broker-dealer to investors, long or short, is a much more important and interesting question than trying to establish the eventual market results as the “fault” of shorts’ greed. The longs were just as greedy, they were just stupid. The broker-dealers were just as greedy, they may have been dishonest, and that’s what investigators are investigating, whether they were wrongfully dishonest to the customers to the point where they can be prosecuted.

You seem to just like some sharks better than others. I don’t like dupes (even when they think they are sharks) because they are lazy investors who rely on ratings agencies when they should do their own homework. I don’t like sharks that lie or wrongfully take advantage of dupes, that’s against the rules. But by going after the shorts, it may be a contrarian and uncommon view to get publicity for your book, but you fail to make the case there was anything they did at all that was wrong. You come close to making, but in my view don’t make, some “but for” causality relating to Magnetar and CDOs being the source that sustained the market on the way to collapse. Well, I could much more easily make “but for” causality arguments relating to broker-dealers in the middle of the trades as well as the long investors. Big deal.

You fail back by saying that they at least had a duty to point out to people that the whole thing was a house of cards. Whether or not they had skin in the game, some people did — people like CRL called regulators and Congress, who often didn’t recognize the problem and certainly didn’t do a damn thing about it. As a matter of fact, there’s an article recently in the UK Daily Mail about how hedge fund guys short the banks (Paul Singer, Jim Chanos) went to G-7 Finance Ministers and told them how the banks were skating on no equity, stuffed to the gills with bad assets and were ready to collapse, and that’s why they were short these banks. The idiot government people said, “that’s nice, what do you think about regulating HFs?” Not that this happened often, but in my personal experience it happened enough. The shorts didn’t lie to anyone, “living unhealthy” (the longs, blindly taking on too much risk for return; funny, you don’t see the patient as responsible for their own condition after too many nights partying hard) or “faking the tests” (lying to the doctors) in your crappy medical analogy. They just took out the insurance policies. The longs were the ones who lived unhealthy. The banks running the lab may or may not have faked the tests (helped clients hide debt and losses with derivatives) for the doctor (regulators), and that’s who you should go after.

You’re totally wrong for throwing brickbats at the shorts. Aim at the big banks in the middle who may have breached their duties to their customers and the regulators — or not.

You are ignoring the elephant in the room and are mistakenly analogizing from regulated markets.

Lewis’ shorts were not smart. They were damned lucky.

These trades were subject to massive wrong way risk. Google that. That does not make this a smart trade, it makes it a profoundly risky trade, as in the odds were high that if your bet was correct, the person on the other side of the trade would not be able to pay you. What good is it if you are “right” as an investor and don’t get paid?

With that kind of a trade, it is essential to know who your counterparty is, who the ultimate risk bearer is. Saying “it’s a CDO” and going no further that means any short who thought like that (which is the position you are defending) is every bit as much of a chump as the longs you are decrying.

The only reason these guys did well was they were lucky in the timing of their exit. Burry got out two weeks before Lehman. The Cornwall guys were dealing directly with Bear, they understood who their counterparty was and were most attuned to the risk of non-payment.

These CDOs were ultimately rescued out by goverments. You are defending a trade that was successful on a large scale basis ONLY because it created such large scale damage that the dealers were bailed out.

I’ve had equity short positions. I have no philosophical issue with shorting in regulated markets. This is a different kettle of fish and you seem unwilling to think through the issues and recognize the differences.

These trades were subject to massive wrong way risk. Google that. That does not make this a smart trade, it makes it a profoundly risky trade, as in the odds were high that if your bet was correct, the person on the other side of the trade would not be able to pay you.

If we grant that the short subprime trade was entirely dependent on a government backstop for the counterparties, then the shorts can either be predatory OR lucky, but not both. The way I see it, there are two scenarios:

1.) The shorts knew that the big banks wouldn’t be able to pay off on their bets. However, they (quite rightly) figured that in a true crisis, the country’s political and intellectual leadership would be unwilling to suffer anything so wild, so uncontrolled, so nineteenth century as a true bank failure, and so they could be depended upon to step forward with the needed capital when the time was right. And sure enough, at the moment of crisis, the entire litany of Serious Thinkers lined up behind the bailouts and in favor of paying off the shorts’ bets.

I personally disagree with bank bailouts, but nevertheless must resign myself to living in a society in which their advocates — all the Serious Thinkers like Tim Geithner and Dan Gross and Andrew Ross Sorkin and Willem Buiter and Martin Wolf and the TARP authors in Congress and all the rest — have the power to put them into practice, at least until the “extend and pretend” is finally no longer a viable policy. Still, if this really was the shorts’ plan all along, I must confess a certain appreciation for their Rhett Butler-esque ability to turn a system of corruption and moral hazard toward their own profit. There’s a part of me that wants to say, if the public is so eagerly begging to be ripped off like this, why not oblige them?

2.) The shorts believed their counterparties would be able to pay off on their bets. Maybe they believed subprime would be a relatively contained debacle, maybe they didn’t understand how exposed their counterparties were. In this case they were indeed lucky, not shrewd or foresighted.

Unless these short sellers had certain (future) knowledge that the government would backstop financial recklessness, they were gambling. If they were gambling in the belief that a government bailout AT TAXPAYER EXPENSE would cover their shorts, they were preying on the taxpayers. Ergo, both speculative and predatory.

There were a LOT of people arguing for variants of number 2 throughout 2007 and even right up until Lehman blew. “Subprime is contained” was basically the consensus on Wall Street and in academia at least until Bear Stearns went pear-shaped. So, yeah, they were drinking the Kool-Aid, but so was almost everyone, including all the yield-grasping investors who were buying the crappy mortgage paper.

Everyone knew it was #1, but pretended it was #2. It took a bunch of guys, deciding not to trade with Bear one day, to tip #2 into #1 and get everyone paid-out once the risk pool became too convoluted to manage/predict/game.

“The only reason these guys did well was they were lucky in the timing of their exit.”

And the timing of their exit was… WHEN, exactly? The mezzanine tranches of CDOs that were shorted lost their value in market terms and/or were written off in late 2007 and early 2008 long before the bigger banks fell in fall 2008. It was a natural thing to close that short, kind of like buying back a short stock when it was bouncing into single digits before a BK filing. Goldman is the only major player who was thought to be short in fall 2008. This is totally aside from measuring and monitoring the counterparty risk, which smart traders do. Even Paulson’s $10-20bn reported haul for all his investors was insignificant compared to the collective trillion-dollar balance sheets of his super-big-bank counterparties. Boo hoo for them. Maybe if they had managed their risk better on everything else they wouldn’t have needed the government bailout. None forced them to play musical chairs.

So fine, Yves, call the shorts dependent on the government to cover counterparty risk when it came down, or smart or lucky that they covered their positions before it all came down. But there’s a big difference between that and holding them morally responsible for broker-dealer greed and buy-side greed when the latter two sides of the trade got totally hosed.

Your shorts are showing. Or your irrational anger towards them at any rate.

you’re missing the point, which has nothing to do with the value/validity of shorting, but how it was used to help inflate the bubble in a market that was fraudulent at every level, the exact opposite of what most people would consider healthy shorting.

If we want good gov’t regulatory solutions to address the issues in the crisis we first need to understand how and what went wrong. Investigating is hard, but telling the story based on those findings isn’t. Lewis leaves the impression he’s investigated thoroughly, and can tell the whole story, but he really hasn’t.

The story is the bubble,how it inflated and ultimately popped. The focus here is on the shorts place in that story as told by Lewis.

Understanding the shorts role in keeping the helium flowing is important. I think we can argue shorts morality later, after it becomes clear how they were involved.

But If the shorts actively facilitated blowing up the bubble as they were putting on their shorts, its tough to argue they were performing their market policing function.

You are failing to understand the mechanics of the trade and confusing MTM gains with real gains.

The MTM gains considerably preceded the obligation to pay out on the CDS. And while the book does describe how some of the dealers were trying to “buy” CDS as desperate, last minute hedges, CDS usually are not transferred (the usual mechanism is an offsetting swap). The book describes in some detail how hard it was for Burry and Cornwall Capital to exit their positions in 2008. The counterparties were giving then prices that were clearly unrealistic just for position marking purposes, an exit would be even worse.

The CDS in the CDOs were so-called “pay as you go” CDS. They pay out when losses occur. Losses, not delinquencies. They aren’t binary like corporate CDS.

The BBB tranche of subprime bonds gets wiped out when losses on the underlying mortgage pool reach somewhere between 8% and 12%, the exact level varying by deal. So the trade would not pay out in full until the losses reached that level (assuming the counterparty was good and did not find some basis for fighting/delaying payment).

Moody’s in September 2009 showed subprime losses at roughly 10% (the chart is hard to read). So even as of Sept. 2009, some BBB tranches would be wiped out, others somewhat intact.

By contrast, Moody’s projects total losses at 25.3%.

Someone, ultimately, has to get paid by the CDO for the CDS in the CDO to be worth anything. If there are doubts that the other side of the CDS will not be able to pay, that is an issue.

Short sellers don’t keep interest rates artificially low. For every seller there has to be a buyer and if some jackass wants to pay top dollar for some shitty bond that he hasn’t even researched, then someone will sell it to him. You can’t regulate stupidity out of the market.

These short sellers had massive cojones. They trusted their own due diligence, bet against almost everyone and took huge risks. Everyone from major analysts, Wall Street legends, international bankers, even Greenspan and Bernanke went on and on about how the US housing market “never loses value.” To fade that massive sentiment was daunting, and the way capitalism is set up if you take big risks and win, then you are due big rewards. The housing market didn’t crash because 4 guys saw it coming. The housing market crashed because a lot of very dumb people became greedy and complacent, at 30:1 leverage. A few guys making a couple hundred million dollars didn’t cause a loss of several trillion dollars in worldwide equity.

All this moralistic searching for who was ‘right/wrong’, ‘to blame’, etc… makes my head ache. Traders aren’t about solving society’s problems, they’re about making bets. All these participants are about making money – the trade is ‘right’, if you make money on it. … and if there’s no one on the flip side, then create some demand by telling a different story. There will always be someone to believe it.

So, it goes in a totally ‘free’ market. It’s like the Colliseum – some are lucky, some are crafty, some are quick, brawny, have more armor, etc… but it’s never about justice or right/wrong.

If you crave justice in all this, or a level playing field that’s based on right/wrong – turn to your politicians.

It would take some doing to find a better illustration of moral bankruptcy. So traders like to trade, and as long as someone agrees to the other side of the trade, it’s fine? By that logic, most pedophiles are in the clear too (they are seldom rapists, they typically seduce children into having sex with them).

The reason speculation is endorsed is that it is supposed to help provide liquidity to activities that serve socially productive ends. That is why securities firms and banks are licensed (restricting entry and raising their profit potential, although now they have become so big that they can defend many of their oligopolies) and enjoy state support.

This activity was not only not socially productive, you applaud it. Sounds like you came out on the winning end of the “financial services industry v. taxpayer” trade.

That is what I think our host Yves would call an ad hominem attack. You never dealt with my point.

And you are utterly wrong with respect to my knowledge of capital markets. I have over 20 years of first hand experience, in New York, London, and Tokyo, as well as some secondary financial centers. I suspect I’d trump you hands down in a resume comparison in terms of real world dealing room experience. So don’t try pulling a rank card when you probably don’t have one. I’ve seen what rubbish this “consenting adults” theory is via my own first hand experience. It’s just an intellectually lazy defense for market abuses.

The problem is clearly there is not enough publicity for Econned so when the heck are you going to present for the Stamford CFA Society. We had Zuckerman do his canonization of Paulson, would be great to have you up in the area and market your book and actually point out why some of these trades were not as clever as they may seem.

This is great stuff, Yves–pieces like this are why I read you every day.

This whole episode has made me wonder about the supposed “bond vigilantes.” I seems to me that the pension funds, insurance companies, etc. have no choice but to buy mispriced paper at this point and hope for the best. They have no ability to sit in cash and wait for better prices–the pressures for immediate returns are simply too great.

I know about the James Carville quote, but that was a long time ago and in a different place.

I seems to me that the pension funds, insurance companies, etc. have no choice but to buy mispriced paper at this point and hope for the best. They have no ability to sit in cash and wait for better prices–the pressures for immediate returns are simply too great.

If they’re simply taking the easy path, bowing to pressure and bailing out of cash and buying right now, with the corporate and municipal bond market at current bubble levels, they’re going to suffer the exact same fate as the 2006/2007 BBB subprime buyers. More power to anyone who takes the other side of their stupid bets and turns a profit.

Could someone explain the scheme to a simpleton (me:)? I come it by analogy – shorting a stock. I don’t understand how betting against something makes the price go higher.
thanks in advance.

“He takes out ten life insurance policies on the patient and finds a way to alter the test results so everything looked normal”
I can’t understand the analogy because the average person can’t take out one life insurance policy on someone, nevertheless ten, and I see all sorts of people who look like they should immediately drop dead who live for decades.

The reason you have difficulty understanding the analogy is because most people, unfortunately, don’t fully realize the extent of predatory jurisprudence and predatory legislation leading up to this. (Should you ever familiarize yourself with the Private Securities Litigation Act of 1995, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 and the Commodity Futures Modernization Act of 2000 — not to mention that bankruptcy legislation under Bush, and the Supreme Court’s privatizing of “emminent domain,” etc., you will comprehend everything.)

Laws apply differently to different parties and income levels. The analogy is correct, because that’s the way the laws and legislation allowed for it — the removal of legal risk, anti-fraud and anti-manipulation, and the creation of ultra-monopolies and their ultra-leveraging.

Many people knew there was something rotten in the sub-prime market, and that there would be great financial consequences. Virtually no one anticipated the extent of the crisis. One of the rarest abilities is the ability to gauge how much weight new information should be given. It’s interesting to me how the market held up well almost until Lehman failed. It was as if the Bear Stearns’ failure, and all the other bad news coming out at least monthly from the Summer of 2007 on, didn’t matter.

A short seller from the ’70s said, [I paraphrase]: ‘I’ve made an enormous amount of money because people don’t realize how bad things can get.’

Does anyone doubt the book is going to be a bestseller? There is an inverse relation between the sales this book will achieve and its depth or comprehensiveness. Lewis never claimed to prove a crime or provide the most intellectual treatise. Entertainment was a major objective, which I think he achieved beautifully.

I think people need to take a chill pill. Jealousy can be a terrible thing.

There is no crime in entertainment. A factual book can be entertaining. But a botched job of analysis that’s entertaining is a botched job, whatever profits accrue to the entertainer. Lewis is smart enough and entertaining enough to inform properly AND entertain. He didn’t.

What could have slowed down the subprime CDO market was that no-one wanted the BBB tranches much, and the originators didn’t want to be stuck with them either.

The clever traders noticed that, contra the received wisdom, the AAA tranches of CDOs were actually *much* more expensive than the BBB. Via the CDS market, they could profit from this mispricing, by buying insurance on the AAA (in effect, shorting it, synthesizing lots of the AAA that the market was crying out for) and selling insurance on the BBB (in effect, gobbling up all the BBB that no-one else wanted).

So that unblocked subprime issuance and it went into overdrive.

Now to the life insurance analogy: first, it didn’t matter if the AAA didn’t immediately drop dead, because if you weren’t sure how long the AAA would last, the yield on the BBB was big enough to fund the AAA short and still show a profit. Second, you are right, with life insurance there is actually no way you can just look for some sick-looking people and buy loads of life insurance on them in the hope of trousering a giant profit when they croak. The life insurers hit that problem in the mid 18th century and there’s been a law against it ever since. But with CDS, you can buy and sell as much as the market will bear, irrespective of whether you have an insurable interest or not. And that can get out of hand. The combination of stupid low interest rates, stupid investment statutes, stupid regulations, stupid ratings, stupid incentive schemes, stupid CDS product rules and stupid herd instincts meant that there was a *lot* of appetite for AAA paper that these clever traders could satisfy, without having to put up much of their own capital at all.

As you can see, this is far from being a straight ‘wicked shorts’ story. Or any kind, really: you can easily believe that shorts are good (as I do) while seeing this kind of damn-the-consequences vandalism as something else.

Now to how to share out the blame. Yes of course the dealers, banks, regulators, Fed, politicians and economists all had a hand in it, over many years (obligatory ECONned plug goes here – it sets out the whole back story).

But it does seem perverse to me, when a whole series of bombs go off, to blame the bomb designers, the explosive manufacturers, the fuse manufacturers, and so on, and make heroes of the guys who lit the fuses, especially if they don’t have the excuse that they had no idea what they were doing.

“We fed the monster until it blew up”, says Eisman. I think you could say he had a rough idea what would happen. Though he should have added the word ‘everybody’ to be really accurate.

I think you’ve got the gist of it. A lot of this “shorting” really started as “capital structure arbitrage” within the CDO/SIV structures on the part of these hedge funds. It then morphed into the trade that has become known as “shorting” when the obvious angle you described became available and more widely understood.

I would also love to hear Yves talk more about the Magnetar operation (I’ve not read her book yet). The way I heard the story, they damned near went bust on this operation during a few rallies in credit. It was a close-run thing, not a money-printing operation.

The other amusing part of the whole episode, which is widely under-reported, is that many credit and equity analysts at Lehman and Bear Stearns understood the pitfalls, yet were ignored by their trading/prop operations.

Thanks for the attempt. I am reading the other comments, the wheels are turning, and the hamsters are running their hearts out. The discussion board here really helps to understand this stuff! KUDOS to the commenters!!!

I can understand this niffty quote:
“But it does seem perverse to me, when a whole series of bombs go off, to blame the bomb designers, the explosive manufacturers, the fuse manufacturers, and so on, and make heroes of the guys who lit the fuses, especially if they don’t have the excuse that they had no idea what they were doing.”
I think it is an insight that someone could be making part of a bomb and not realize that it is a bomb. There were those who knew it was a bomb, but the majority didn’t.

One other point – in the links (below)the statement is made that “the product economics don’t work.” I note that I have asked the question many times whether some of this stuff is actually “economic” – that is, if it weren’t for sleight of hand, confusion, fraud, that it could not stand on its own.

On Clearinghouses Economics of Contempt. EoC and I are in an infrequent point of agreement here. I’ve never liked the idea of clearinghouses for CDS, not simply for the reasons he gives, but for the difficulty (read impossibility) of having counterparties post adequate margin (as in the product economics don’t work, so dealers will force inadequate margining). And he is right that not very liquid products are not well suited to central clearing (higher capital requirements and other forms of intrusive regulation are better remedies).

Sure, but who is accused of lighting the fuse? Certainly not the short sellers, they were SELLING, ie, they were broadcasting that they thought these assets were overpriced. The guys who were bidding up the crappy assets were the BUYERS: they were taking investors money– YOUR money, most likely– and BUYING overpriced assets, thus not only lighting the fuse, but dousing it with accelerant via 30:1 leverage. I’ll never understand why people cannot figure out this very basic concept of capital markets.

Richard Smith said; “Now to how to share out the blame. Yes of course the dealers, banks, regulators, Fed, politicians and economists all had a hand in it, over many years (obligatory ECONned plug goes here – it sets out the whole back story).

But it does seem perverse to me, when a whole series of bombs go off, to blame the bomb designers, the explosive manufacturers, the fuse manufacturers, and so on, and make heroes of the guys who lit the fuses, especially if they don’t have the excuse that they had no idea what they were doing.”

Yes, it is perverse and VERY deflective, because it serves to mask the most culpable in all of this. The blame goes to those who created the conditions that allowed all of these weapons to be created and at the same time allowed the debt trapping easy credit component that is an integral part of the design of all of these weapons. Some pigs are far more equal than others!

This was not just a happenstance gang rape by a bunch of lusty wall street perverts that can be explained away as; “all had a hand in it”.

At a minimum there is a conspiracy of class here in all of this in that none of these offensive subhuman ass wipes were members of the ever growing homeless class in scamerica. They were all well heeled, and well educated, human flops emanating from the far to obnoxiously revered over class.

A greater conspiracy of class, that needs far more discussion, is to be found in; the ties that bind the wealthy ruling global elite, the ties to their global central bankers, and, their ties to the neo-con ideologues who have captured their fancy with their planned ruler and ruled world concept that is now being incrementally implemented.

During the Depression of the 1930s Myer felt a responsibility to contribute something to the community that had assisted him in achieving business success and a personal fortune. Rather than terminate workers in his Department Store, all staff, including himself, had their wages cut. Relief work was personally financed by a 22,000-pound sum, to provide employment opportunities. For the unemployed at Christmas he financed a Christmas dinner for 10,000 people at the Royal Exhibition Building, including a gift for every child.

——–

The class you speak of is incestuous and with god’s divine blessings moves to further enslave us all…amen.

Anyone caught uplifting his fellow man will be derided and cast off for the crime of being a heretic of class distinction.

They control the voting process (as you rightly proclaim) hence they run the show, from all levels of government to capital/financial markets. Total decoupling from this process is the only way to react as you have stated many times here.

Skippy…Sidney Myer once commented: the job of capital, was to create jobs. Wall St. and Company seem to think_it is_for speculation. Our supposed best schools out put and best practices are *all* being applied as a fulcrum to leveraged speculation…it will end in tears me thinks.

First sign of class collapse aka societal collapse: is the cannibalism of the lesser classes to off set the tops losses *when they screw up*, second is the top classes changing or modifying the paradigm they feed the lower classes in an attempt to beguile the uninformed lower classes aka gods punishment for straying and austerity programs for them, lastly is the feast of priests, when the lower classes consume them as a last resort aka pay back for lies writ large, contracts left in taters.

According to Greg Zuckerman’s The Greatest Trade Ever, which is also about subprime shorts, John Paulson came up with the idea of using a synthetic CDO in which he provided the equity tranche to create a cheap short position. Paulson took down the ENTIRE short side of those trades. Since the equity tranche is only about 5% of par value, that meant he was net short 95% of the value of the CDO. Goldman and Deutsche did some of his CDOs. Bear was so uncomfortable with the ethics they turned him down.

So the guys who lit the fuse were in the case of Paulson, Magentar, the hedgies and dealers who imitated them, also bomb designers.

And you seem to miss the point re Eisman. Even after he understood how destructive the CDS were (read his remarks above), he persists in doing the trade. This is after Lewis has repeatedly featured Eisman as being on the side of the lower income borrower being targeted by the credit machine, who sees his short as a virtuous effort to punish predators. When it becomes apparent that he is a critical part of the predators’ food supply, he willingly continues to feed them.

Circa 2004, I recall noting the graphs of average house prices for a number of cities that were abruptly heading north. I thought, well that won’t last too long.

Some time later I noted that the graphs were going vertical. I thought, How can one short average house prices?

I then noted tombstones for an RMBS and a CDO. Voila, there it was. Buy the CDO, I have an insurable interest; and, buy a CDS on the CDO. When I priced the trade I found that the CDS grossly underpriced and the CDO was grossly overpriced. The spread was roughly 60%.

Why was the concurrent observation of an RMBS and a CDO critical? The CDO was comprised of the unsold equity tranches of the RMBS; i.e., those tranches way down on the subordination schedule. That is, the CDO was funded by tranches that had expected values of zero! Don’t look at the ratings look at the subordination percent.

Why was insurable interest important? With that any suit I might bring would have standing.

As to shorts, they serve an important purpose and I am not inclined to kick on their dog.

As to whether Mr. Lewis’s ‘heros’ are dumb, shrewd or lucky, I am inclined to believe that they are shrewd, lucky and amoral.

The government intervention should have been nationalization. On that score, I am quite probably naive. The government’s pandering to the auto unions and the trampling of secured creditors rights is testamony and example that you can neither trust nor rely on the government to do the lawful thing.

I saw Mr Lewis and he makes a seductive presence. He doesn’t have it entirely right; however, he does provide insight. His protagonists are more notable for their ability to see what is and what might be than for any other attribute. Their actions and point of view are instructive as to how they perceive their responsibility to society in general.

If someone thinks a bond or synthetic bond like product/fund is overpriced what are they supposed to do? Not short it?

I don’t understand what the difference between shorting a stock and shorting some bad mortgages. Just because the counter party may not be able to pay doesn’t make it wrong. You can to take into account counter party risk. And you can’t blame people for the Feds decisions on bailouts unless they actively lobbied for them. These people didn’t have to get paid 100% of their bets, I’m sure some of them are even a little surprised the government is that dumb.

We need people shorting, even shorting in large and risky ways. Its the only way to keep markets in line. If the only way to make serious money is on the long side then only people with a long bias will be in the market.

If you are shorting something you are turning around and selling it to your clients (like GS) then that is wrong. But if your shorting things while screaming at the rooftops what a disaster they are I don’t see the problem. Shorts can hardly be called on for the idiocy of blind AAA investors.

I’ll readily admit that I both read and enjoyed Michael Lewis’ book. Moreover, I’ve lent the book out to two people, and they both enjoyed it as well. I think Yves’ criticisms are pretty no the ball (as usual), but I think she (and a lot of the commentators) are missing the point that most people read Lewis for entertainment, not information (and Lewis is an exceptionally good writer). Lewis sort of implies that he doesn’t expect his work to be considered otherwise when he mentions that he didn’t focus on Paulson because Paulson’s approach wasn’t nearly as interesting as Burry’s.

Anybody who reads Lewis’ Bloomberg pieces can grasp pretty quickly that he doesn’t really follow the markets anymore, and that he has no real understanding of much that happened in the markets since the time he left. Jonathan Weil’s columns are far more informative and relevant, for example, than Lewis’. Having said that, Lewis’ are much easier to read, and probably much more popular. They’re entertainment, and readers view them as such.

To compare The Big short to Econned (the part that I’ve gone through so far) is like comparing a Ludlum book to War and Peace–they’re both written for completely purposes.

I am a fan of Yves Smith. I have read both books, and Smith’s book is clearly a more serious book, and the one to read to try to understand the whole picture of what happened. Lewis book, however, was not attempting that, so to judge it by the same criteria as Smith’s is misplaced.

I don’t believe that Lewis was claiming that the shorts he wrote about were heroes at all; they were just people who saw what was happening early, and had enough conviction to actually do something about it. I think calling them the villains is ludicrous.

Even in this post, it is clear that the villains were the broker-dealers, whose measures of risk and incentives were very wrong; and the regulators, who devised the whole system in the first place. Also clearly villains were the money managers of the dupes, who bought things they clearly did not understand. Why are they given a pass? They lost their investors massive amounts of money. And at the end of the day, the biggest villains were the people in government who chose to bail out the big banks, and amazingly leave the bondholders whole and the management in place.

Far down the list are the shorts who recognized the mispriced risk and took advantage of it.

You also can’t compare Yves with Lewis in the way they treat their customers. Lewis throws out his comments in a one-way fashion, while Yves posts her’s here and takes on all comments.

It takes a lot of fortitude to withstand continual challenges to your points, Yves, but please understand that your replies often contain that AHA! moment for me, where I just needed one more bit to round things out.

In my mind, that’s what separates you from the rest. You know your stuff, but you’ve also mastered the new delivery methods that most haven’t.

Kudos, take a deep a breath and pat yourself on the back. On to the next reply…

It would be interesting for the Financial Crisis Inquiry Commission to have a chance to question a panel including both Yves Smith and Michael Lewis. Both pieces of research and reporting are relevant to their mission.

“[I]Eisman recognizes that the subprime market is a disaster waiting to happen, a monstrous fire hazard that, once lit, will engulf the housing market and financial firms. Yet he continues to throw Molotov cocktails at it. Eisman is no noble outsider. He is a willing, knowing co-conspirator. Even worse, he and the other shorts Lewis lionizes didn’t simply set off the global debt conflagration, they made the severity of the crisis vastly worse.

So it wasn’t just that these speculators were harmful, and Lewis gave them a free pass. He failed to clue in his readers that the actions of his chosen heroes drove the demand for the worst sort of mortgages and turned what would otherwise have been a “contained” problem into a systemic crisis.[/I]”

I’m asking this question as someone from the equity/option side & without much experience on structured debt.

EDIT – just realized that Richard Smith may have answered my question.

I think I know what you’re saying. ie Without the selling demand for the CDOs (created by guys like Eisman synthetically short-selling) the buy side demand for these CDO’s wouldn’t have been as great. Therefor in some way the short-sellers perpetuated the market?

I’m a bit surprised Yves would write this as she’s no airy-fairy academic. In almost all macro/large trades like this there’s a much bigger supply of longs then shorts on a dollar basis. It happens with OTC BB pump and dump scams, Bre-X mining deposit scams, telco toxic finance etc etc does it not? Yves is writing about a world where buyers and sellers are relatively just as aggressive. A world that doesn’t exist except in rare circumstances of bear market panic. If Eisman or short sellers dropped out of the picture, wouldn’t there would still have been CDO buyers (like the market for stupid longs/lemming fund managers would have run dry – yeah right) but the CDO’s would have been mispriced even higher?

Kudos is due Yves Smith; a cogent, insightful and damning assessment of Michael Lewis’ “The Big Short: Inside the Doomsday Machine”—whose comic book version of good vs. evil is the way the financial elite want the story of systemic extortion, fraud and corruption explained to the masses—instead, to fully comprehend the credit crisis, read Yves Smith’s “Econned: How Unenlightened Self Interest Undermined Democracy And Corrupted Capitalism.”

I was a research assistant for The Big Short. From the beginning, I was stunned by the depth of Michael’s understanding of the subprime crisis. You can’t hold it against him that he chooses to keep his understanding of the essential details “under the hood”. He’s trying telling to tell a compelling story.

When I sent him my former student AK Barnett-Hart’s senior thesis, The Story of the CDO Market Meltdown: An Empirical Analysis, he read all 115 pages the night I sent it and pointed out an error that AK or her advisors didn’t catch! This thesis won the award for the best thesis in the Harvard economics department in 2009 and has since been read by hundreds of people. Apparently Michael caught the only error, and none of the material in the thesis was particularly new to him.

I could not disagree more with this statement: “Lewis repeatedly and incorrectly charges that no one on Wall Street, save his merry band of shorts, understood what was happening, because everyone blindly relied on ratings and failed to make their own assessment.” I think many, many people understood that there was a real estate bubble and a credit bubble as it was happening, but most people just cynically went with in one way or another. Some people were ultra-cynical — you had Angelo Mozilo playing golf every day at Bel Air and selling millions of shares of CFC while ruthlessly originating and selling bad mortgages. But other people — perhaps two-thirds of the participants at the subprime conferences Lewis describes — were cynically milking the bubble in more mundane, paycheck-to-paycheck ways. In Lewis’ telling of the subprime story, there are no innocents. Eisman is just the bad guy who was right. None of us — not least Lewis – like the fact that we lived through this dog-eat-dog time in the financial markets, but that was just the reality, and, as someone who lived the events of this time pretty closely, I think Lewis’ telling of the story is pitch perfect.

Well, we can certainly hold against him his reprehensible comment on “60 Minutes” that the issue of interest wasn’t the mass criminality but rather the mass delusion.

Without the delusion, the criminals wouldn’t even exist. Every mania produces its share of operators, schemers, and con-men. And after it blows, everyone looks to place the blame somewhere other than their own credulity and willingness to believe “this time it’s different.”

In this regard, the similarities between our own crisis and the South Sea Bubble collapse are striking. Here’s what Charles MacKay had to say about the English citizenry’s reaction to that crisis:

The state of matters all over the country was so alarming, that George I. shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon the South-Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people,—the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.

Personally, I find the mass delusion that manias create to be of much more concern and consequence. The operators and schemesters they succor are just some of the many eddies they leave in a very big wake.

Thanks for your kind word about the blog, but I frankly was not terribly impressed with the student’s paper in terms of providing insight into the CDO market. It was probably seen an impressive exercise from a statistical analysis standpoint, hence the reason it was well received, but that is a different benchmark.

Her thesis contained very little in the way of new information.

We are by now accustomed to reading brain science/sociology headlines like, “Scientists show that a person receiving a major emotional trauma earlier in the day is more likely to drive unsafely.” In other words, something that was previously in the sphere of common sense is now cordoned off into the sphere of things that can only be proven by experts, using complicated statistical analysis.

Similarly, the paper in question’s main results are statistical illustrations of things that are widely known and understood:

1. There were more problems with the credit quality of subprime RMBS than with, say, commercial loans.

3. The ratings agencies relied too much on models without looking through at underlying loan quality.

The paper contains one interesting statistical result:

Some of the investment banks underwrote CDOs with especially bad qualities (e.g. JPM, MER, Citi), while the Goldman CDOs did a bit better than the norm. dataset.

The paper also contains a statistical “result” that “violates the consensus view”:

The conflict of interest of ratings agencies was not an important factor in encouraging them to misrate securities.

This “result” is deduced from the fact that after discounting for all other factors, a particular ratings agency was not any more likely to rate a CDO tranche AAA if it came from a particularly high volume client.

This logic ignores the fact that the high fees from rating complex structured products were a major motivation for the ratings agencies to rely on computer models and recent data, and NOT to do the more stringent look-through analysis that the author of the paper criticizes them for not doing.

“Now in our little fable, what happened was that someone saw the patient on the street and recognized he was a prime candidate for heart failure. He takes out ten life insurance policies on the patient and finds a way to alter the test results so everything looked normal. The doctor, conditioned to trust the tests, believes them rather than his lyin’ eyes, and fails to take action.”

The doctor is complacent and he failed the patient. The insurance companies were negligent for not evaluating the patient and/or hedging their risk. Both should know that lab tests can be wrong, and in the case of ratings agencies, money managers should have known that the mortgage securities’ ratings could be willfully manipulated; geez, anyone who reads Barry Ritholtz once a week was treated to this insight ad nauseam. Did Eisman willfully manipulate the CDO’s? No, but even if he did, the ratings agencies are paid to find that out. And if the ratings agencies fail, then whoever is buying these CDO’s and MBS’s should do their due diligence. Bernanke, Geithner and other regulators should have seen a real estate bubble.

Lewis is pointing out that very average people who were NOT complacent could figure out that ratings agencies were misallocating risk and that fund managers were buying things that they knew nothing about and that regulators were asleep at the wheel. For them to ignore this inefficiency would have been money management malpractice, and all these guys were money managers– I just wish they had been MY money manager. That’s a free market, like it or not.

Your reasoning is a major logical fallacy, judging process by outcomes.

How is a doctor supposed to diagnose? He’s supposed to put a stent into everyone who walks into his office looking bad? How would you suggest he treat a patient whose test results show nothing amiss? What ailment is he supposed to treat? He can’t make a diagnosis of any sort with bogus test results.

The fable has the passage: “You have a well established patient with a known heart problem and high cholesterol… You ask him to come in quarterly, rather than annually. He *continues to look even worse*, yet his test results continue to show nothing more amiss than before he started to look so awful.”

I’m a doctor; I’d use a different lab. Doctors are paid to know the limitations of their lab tests and other diagnostics. Your understanding of medicine is no better than your understanding of capital markets.

The real scandal is that public funds back-stop all the gamblers who “win” regardless of their position on Subprime and credit defaults this side or that, and that public manipulation is not well understood or corrected. Is that why we all consent to be taxed? To pay gamblers who practice financial extortion one level or another?

I have frequently thought while reading Econned that only a woman could write this point of view, both deeply in the know, thoughtfully critical and compassionate. Most males are hung up on using their smarts to demonstrate more of that winner take all peacock boasting, evidenced in Lewis’ point of view.

Allowed free reign, profit-seeking knows no bounds. Ultimately, profit-seeking will always lead to gaming the system itself – and that is what Yves is describing. The solution is vigorous regulation and vigorous prosectution of miscreants. Someone above in this string noted that such regulation is a feminine, nurturing, protect the cubs, type of behavior and I am convinced that women like Elizabeth Warren or Yves Smith would do it best. If Congress is wise enough to create consumer and systemic risk regulators, I would hope that these two women would apply for those jobs.

Here’s a little statement for our legislators. I have most of my money in cash and gold and I am putting off discretionary spending. I am nearing retirement and want to be certain I can retire comfortably. I am afraid to invest in the markets because they are less than honest – and I am not a gambler. If you want my money, and the money of the millions who are sidelined just like me, FIX THE SYSTEM, INVESTIGATE, INDICT, AND PROSECUTE THE MISCREANTS, REGULATE WALL STREET LIKE A WAYWARD CHILD – DO NOT SPARE THE ROD. MAKE THE MARKETS SERVE THE CITIZENS, NOT THE OTHER WAY ROUND. Then, I would gladly give an honest broker a sack of my money to invest in the USA – until then, I will continue to seek not return on my investments but the return of my investments.

hear hear. my exact sentiment. guess what we are saying is, we want it back like it use to be. but i now know better. not going to happen. it is a rigged game. plan accordingly. hard assets for main street is my line of thinking.

Now in our little fable, what happened was that someone saw the patient on the street and recognized he was a prime candidate for heart failure. He takes out ten life insurance policies on the patient and finds a way to alter
the test results so everything looked normal.

Did you catch that? TEN life insurance policies

The original sick guy (the underlying subprime mortgage) is going to die. Normally this is the only asset the ‘good’ shorts would be interested in. I think Lewis leaves the impression that his shorts were only shorting this one guy.

But through the actions of the IBs/Magnetars/shorts there are now 9 more insurance policies outstanding on that same sick guy, and he was very sick indeed.

Think about what that means.

The short side of this trade wins, he’s almost sure to die, and soon.
But who loses on these EXTRA policies. There’s no underyling home to foreclose on for these 9 policy holders, so who ever wrote the insurance on these policies pays 100c.

So through the action of this group the losses tied to subprime are 9X larger than the already inflated subprime mortgage market. That mean’s the Countrywides are only a fraction of the losses that will slosh through the financial system

The basic pro derivatives argument says, so what, that risk is distributed to big boys who can take their lumps.

Except when they couldn’t, and no one seemed to realize just how many extra policies were sold.

But the winners on these extra policies need to get paid. That’s you and me paying the winners, through the bailouts.

Think you’re mad now about the payments from AIG to Goldman? Well guess who Goldman passed your money on to. Guys like Lewis’s winners.

And for what? We’re paying and our kids will be paying for the capricious folly of a bunch or people who designed a tool to move money from one pocket to another, which might be fine if one of those pockets didn’t have a hole in it.

Perversely, public fury is directed at the borrowers and the underwater homeoners.

Where’s the fury directed at the guys passing the 9X larger hot potato that suddenly fell in our laps? I’d like to see it.

Once we get that, then we can realize just how much more our regulators and government failed us.

Derivative reform efforts don’t even acknowledge the magnitude of the problem they are not addressing.

But the winners on these extra policies need to get paid. That’s you and me paying the winners, through the bailouts.

Actually, nothing of the kind “needed” to happen. The bailouts were a public policy choice, undertaken by the country’s elected officials. The alternative of bankruptcy was always available, but we’ve gone so long without bank failures in this country we think they’re impossible to survive and have to be put off to the future at any cost whatsoever. I sent a letter to my Senator, whom I hadn’t voted for in the first place, in opposition to TARP and the subsequent bailouts.

Paying off the shorts is purely a function of the supine interventionists and Nancy Capitalists we elected to Congress. The idea that the bailouts were “tragically necessary and inevitable” is a lie concocted Hank Paulson and Tim Geithner and unfortunately taken up by most of the financial commentariat and investing community.

If we’re not willing to suffer banking failures, we have no right to recoil at the huge moral hazard that public backstops of the banking system will inevitably create.

Monies = electrons of which supply is near infinity and abuse is perpetuate. Physicist’s should be de-crying this kind of folly for what it is, a horrible piece of pseudo science being inflicted upon the global populace for the benefit of class masters.

As much as I love you Yves, I’m with Brandon Adams on this. Lewis making the rounds is exactly the thing we need to start waking people up; it is sometimes difficult for people who follow these issues 24/7 to realize just how asleep the general public is.

Lewis is simply out of his element . While his cause may be noble ( to try and expose the stupidity of subprime buying/lending/securitization ) , his story is completely wrong numerous times and it leaves me wondering whether he knows better and just lied to justify the moral of the story knowing the average reader would have no clue or if Lewis himself got sucked in by ghost writers feeding him their biased view of what happened

Lweis’ book-deal with the devil made me so mad I was planning on writing about it in comments, just to get the anger out of my system. Then I came by this evening and found this great big post.

I heard him interviewed on NPR 3 times in the last few days. He’s getting a LOT of publicity.

He keeps saying only this tiny handful of people figured out what was going on, that everyone at the big institutions was “deluded, ” “there were no adults in the room” and that the big boys like Goldman had become the “dumb money at the table.”

And people are eating this disinformation up!

A right-leaning acquaintence of mine sent me the news of his 60 minutes appearance as it he was someone amazing, and said he was going to get the book right away. Of course this is somoene who admires Enron’s people and thinks there were “just a few” bad apples who did those nasty evil trades.

There were also the few bad apples doing that shocking torture/humiliation stuff at Abu Ghraibe. Funny how that works.

Lewis is not ignorant. He’s lying.

Look at the NC article explaining about how he tells us how Goldman’s positions were net betting AGAINST the subprime garbage, imposed from the TOP down, while the individual traders were unaware of that fact.

FRIDAY, JANUARY 18, 2008
Michael Lewis’ Theory of Why Goldman Got It Right

Michael Lewis, of Liar’s Poker fame, gives an elegant explanation of why Goldman got its subprime position right when everyone else on the Street was disastrously wrong. And I mean elegant in the mathematical sense: it fits known facts and has few moving parts.

As Lewis tells it, Goldman did not use the largely impotent risk management practices that other firms rely on to rein in trading positions. Richard Bookstaber, card carrying risk manager, illustrated in “Conversations with the Trading Desk” how discussions with traders about their large and growing subprime positions were likely to have gone. Lewis argues that a couple of traders who made a case that housing credit was probably going south were given sufficient rein so as to lay on a bigger short position than the trading inventories of the relevant businesses, unbeknownst to them. …

You need to stop writing good articles that, in my view is impartial and focuses on the problem of the system. People should also begin to realize that it is not as simple as “black or white” and things are not always as “mutually exclusive” as it is; on a broader picture, both the buyers and sellers had more incentive to take on more risk, which made the system breakdown worse than it might have been.

If you keep writing such good articles, I will make a serious attempt to dress up as a puppy, find your address and go there, go on my knees and ask you to marry me.

=D Seriously kidding?

Keep up the good work, I don’t have any power or clout nor do I work in the banking/finance industry, but I do enjoy reading your articles, taking simple notes and discussing them with my friends.

Thanks for another great post Yves! Its great how you link the greed of the originators with that of the shorts. Together, with one “pushing” and the other “pulling,” they essentially derailed the world financial system.

Still, while the train of the world economy may have been beset by strong crosswinds caused by the push-pull of the originators and shorts, the bankers and regulators were the drunken conductor and asleep-at-the-switch dispatcher.

AND CONSIDER THIS: Maybe the shorts do us all a favor by bringing the bubble to a head sooner rather than later? How much more development would have occurred if the bubble had continued for another year or two or three?

As usual, great post Your passion and penetrating intellect continue to entertain and educate me. Its great to have you back in full posting mode.

Good for you mounting the ethical high-horse and rightfully skewering Michael Lewis’s new best-seller. I haven’t had a chance to read it yet but I do admit I am a fan of his writing, well his entertaining style anyway. Lewis has a real gift for being able to ferret out the non-fictional threads needed weave a great story which may or may not be a fiction when he’s finished. Interestingly when Lewis was making the TV rounds pre-release to promo his new book he said he felt guilty that Liar’s Poker had fallen into the hands of impressionable young people who had taken the book as a glamorized how-to manual, inspiring them to pursue highly lucrative and undoubtedly unethical careers on Wall Street. Lewis said when he wrote “The Big Short” he wanted to make amends for his previous mistakes (i.e. positive characterizations of criminal sociopaths) and make sure the “bad guys” came out looking really bad this time around. Sounds like he missed the mark. I really wonder why? Did he miss the story himself or is he a cynical marketer that understands a complex story which indicts the entire zeitgeist of American capitalism is never going to be a best seller? If so he certainly had no problem laying all of the blame at the rotten feet of libertarian ideals and laissez-faire capitalism when he penned the “Wall Street on The Tundra” piece about Iceland’s economic implosion for Vanity Fair.

Maybe you’ve been saying things like this before, but if you have I missed it: It seems like a real crossing the Rubicon moment when a blogger who presumably makes her living working in the sphere of financial services takes the position that traders who shorted the housing market were wrong and immoral to do so. That is a powerful indictment with far reaching conclusions. Its not news to you or anyone literate enough to read this blog that Wall Street and Casinos both operate in a manner that require a loser for every winner. In both instances information asymmetry has always been the mechanism that the dealer or the banker rely on to make money. When the money is placed on the table both sides are betting that they know something the other side doesn’t which is ultimately going to make the other party a sucker. As rotten as the whole housing derivative mess is, it just seems a matter of degrees different from any other short or stock market transaction that takes place on any given day. It seems that speculative betting is either OK, or its not. I don’t see how the housing derivative fiasco is fundamentally any different just because it was a six sigma+ over-leveraged mushroom cloud of a disaster. Can you just murder someone a little bit? I don’t understand how the actors involved are supposed to be able to determine the morality of their bets on a case by case basis by analyzing the probability and severity of long-range unintended outcomes.

Forgive my childish craving for a simple, totalitarian answer but as complicated as this subject matter is,
I think it all comes down to the question of the morality of institutionalized gambling.

“Wall Street and Casinos both operate in a manner that require a loser for every winner. In both instances information asymmetry has always been the mechanism that the dealer or the banker rely on to make money. When the money is placed on the table both sides are betting that they know something the other side doesn’t”

Jerry Denim, thank you for giving me the “Ah HA!” moment when I realized that we owe honest Las Vegas casinos an apology for using them as our analogy for what Wall Street financier “banksters” do.

Everyone knows the house has the advantage, and in Vegas, you even know by what percentage. There is such a thing as honest gambling.

No one goes to a casino thinking they know something the other side doesn’t, unless they are counting cards, and then they may actually have an advantage. In fact, if they seem to good at it, they can get thrown out of a casino. The margins at casinos are regulated. And cheaters aren’t tolerated.

Unless you’re unable to grasp the concept of profit margine, or figure out what pays for all the very fancy decorations in the gaming places, you understand perfectly well that your chances of coming out ahead are less than even.

Tell me about it when someone says they plan to INVEST their savings in Vegas!
;->

Yves, I enjoyed your take very much. However, I’m wondering where have you been?

Every single line quoted in this post is also from Michael Lewis’ Portfolio article “The End” from Nov. 2008……..

I think it comes off pretty clearly that these “shorts” knew they were 1) prolonging the madness 2) making it worse, and more importantly, 3) that it was engineered in to the soul of the machine……they knew that the market would eventually collapse on its own weight even though they knew they were a party to its continuation. They didn’t design it. I find it laughable that “if only there weren’t the other side of the trade” guys selling the CDOs the market would’ve corrected.
Again……..from the original portfolio article…..the banks were marketing this trade! The short trade! It isn’t often that Wall St. offers you THEIR head on a platter…….but, when the perfect storm of short-term incentives combine……….thats exactly what the st. did. And, you wanna blame who for taking that bet?

I don’t get the bomb analogy. These banks actively marketed the lighter. It wasn’t like this was an inanimate object and the shorts created the fuse……

I understand the synthetic angle……the arbitrage with the insurance is new to me.

I honestly find it hard to believe that after all the Quick-Loan Funding mortgage originators, and all the ignorant institutional investors, 7-10% appreciation assumptions in the models, and the entire comedy of errors, you admonish Lewis because he lionizes the individuals that, according to your view, lit the fuse to the bomb that wall st. made and then actively sold………..lighter included.

Sure, I get it. They “called for the encore” at the end of the show…….they kept the music going. They were THE source of the synthetic mortgages. Without that market it doesn’t exist. I believe it was too late even then. The banks were already over their head. I do not believe that this would’ve been a “contained problem”.

I will grant you that your thesis certainly should’ve been spelled out by Lewis. I haven’t read all of Lewis’ book yet. But, if I can recall from the portfolio article – which is basically ch. 1 – Lewis does imply, if not outright state…..that Eisman and his crew did, in part, keep the market alive, and thus allowed the banks to gorge themselves even more.

The period we are talking about was not an encore. It was the toxic phase. If the dynamics created by CDS had not been in play, the subprime market would have started imploding in 2005. There was a whole two years of additional loan issuance, and the market also shifted dramatically to more toxic product. Lew Rainieri has said that the quality of subprime loans got dramatically worse starting in 3Q of 2005, not very long after the introduction of the ISDA protocol made large-scale shorting possible.

This was no mere encore. For every $1 of BBB subprime bonds, $10 in CDS were written. The CDS-related losses are vastly higher than the cash market losses. So the people involved in CDS related strategies correctly deserve considerable blame.

Here’s the point that the defenders of free markets and the positive contribution of short-sellers are missing. I thought it was the key point of Yves’ piece and a criticism not of shorting or of any particular short-seller(s) but of the financial/political system and Lewis for missing it, leaving it out or obscuring it.

A stock, bond or subprime loan – and the business or credit each is a claim on – doesn’t come into existence when you short it. But the subprime shorts enabled the multiplication and concentration of the worst subprime risks. One guy in California earning $27,000 per year with one $1 million mortgage and one inevitably screwed lender was reproduced as many times as anyone cared to bet he was going to default, such that when he finally did it caused losses way beyond his $1 million. It’s one thing to say someone betting against something that exists and succeeds or fails independent of that bet is adding value by weeding out the failures (companies, borrowers, other investors who don’t ‘do their homework’). It’s quite another to say we’re all big enough boys and girls, in the Land of the Free after all, that we should be able to create as much of the worst thing we can find to short, too bad if we have to socialise the resulting loss when a $1 million default causes $30 million of damage. That the law allows anyone to do this and then send the bill to me when it’s too big for his counterparty is not my idea of freedom. And I can’t think of a better example of the kind of stupidity you CAN regulate out of the market.

some good points in the article, but your case against Lewis and the shorts is not fair. Two major corrections are in order:
1) Short sellers could not have pushed down interest rates on subprime bonds. To the contrary, by creating additional supply, short sellers would have increased the credit spread, not decreased it (i.e., without short sellers, excess demand for bonds would have driven prices even higher and hence interest rates down, not the other way around).
2)You state: “the shorts were betting against BBB subprime trash, which when packaged into CDOs, had roughly 80% rated AAA. So who were the fools taking toxic BBB risk for mere AAA returns?” Actually, this is not correct. Shorts bet mostly on BBB subprime CDO’s. These CDO’s had subordination levels of around 74%-77%, meaning that 23%-26% of subprime loans would have to default to 0 for AAA’s to suffer loss of principal. At the end of the day, anyone who bet against subprime, from AAA to BBB would have made money. But interestingly, some shorts (most famously MS) did not want to pay a premium for shorting BBB bonds (about 250bps before the blowup), so they bought 6x AAA subprime bonds to be carry neutral. That’s equivalent to buying ATM put options, financed by selling 6x crash puts. You do ok for a small deterioration, but once you go beyond the crash put level you are basically wiped out.

I was repeating Lewis’ 80% figure, which he invokes in his book, which is for reader convenience sake. But the 80% is not a bad figure as far as par value is concerned. The statement clearly implies par value and that gives ~76% for mezz deals. I show typical structures for mezz and high-grade deals in my book.

There are several issues you are missing.

1. Demand by cash investors for BBB subprime tranches was falling off as of 2005.

2. The creation of the ISDA protocol, which allowed for large scale creation of CDS, brought NEW buyer groups to the table, specifically correlation traders. So the robust demand for the synthetic product does not reflect “native” demand. Indeed, a lot of the former buyers of CDOs (obligatory AAA investors) could not buy a synthetic AAA product.

3. There is considerable evidence that a fair bit of mezz synthetic CDOs were created to serve the needs of the shorts, indeed, that shorts would initiate the creation of these CDOs (it is difficult to ascertain how much given both that determining the relevant universe is tricky, witness that the Harvard student’s paper appears to include CRE and high grade CDOs, so it gives a bigger universe than is germane for our discussion, plus the fact that many participants masked their relationship to the trade). Per Greg Zuckermann, Paulson was responsible for the creation of the first synthetic CDO. The Goldman Abacus and Deutsche Bank Start program were created to establish a short position (as in lay off risk, reduce their existing longs via a short position). The Magnetar program, which I describe in Ch. 9 of ECONNED, was clearly driven to create a short position. Magnetar was imitated by other dealers with similar intentions.

4. Inner (lower rated) tranche demand should also have constrained CDO growth. It did not because a fair bit went to correlation traders (who didn’t care about credit quality, they saw the tranches as trading sardines). The rest was dumped into other CDOs or took very aggressive sales efforts to place (this paper was sold not bought, with derivatives salesmen targeting particularly unsophisticated buyers, often government related, like Australian town councils).

I agree that the CDS (mostly put into CDOs) multiplied the risk in such a way that the effects of the subprime collapse were multiplied. However, it seems that the real drivers behind the perpetuation of irrational subprime lending were the buyers of the synthetic CDOs, not the shorts that created the raw material for them. Furthermore, the reason that synthetic CDOs were created was due to the success of cash CDOs, which were swallowing the supply of subprime bonds such that there was a lack of BBB tranches to put in CDOs.

The players that could have brought this market to a halt were 1) The rating agencies (who could have refused to give AAA ratings to 80% of BBB subprime bonds); 2) The investment banks (who could have stopped underwriting the CDOs, thereby refusing to sell insurance to the shorts in question) and 3) The ultimate buyer of the subprime risk (who could have stopped buying CDO tranches consisting of insurance policies on BBB subprime bonds).

Without the shorts, perhaps the synthetic CDO would have never been invented, but the ABS CDO craze could have continued by simply creating more BBB subprime risk via cash bonds. Moreover, it seems hard to argue that the desire for CDS drove subprime market when the whole point of the CDS was to enable the creation of subprime risk without the actual creation of an additional subprime bond.

You might have a look a Ch. 9 of my book, which lays out the argument re Magnetar in much more detail, and how that particular trade (heavily but not entirely synthetic) influenced the cash bond market.

Also see my comment in response to Alan above. Per a different comment earlier in the thread, the ratings agencies were pressuring monolines to keep up volumes in their structured credit business. The monolines were an integral part of why the party continued. Even so, the dealers and some hedge funds (Magnetar included) were creating CDPC (credit derivative product companies, or monoline lites) to rip more fees out of the deals they were involved in and add to monoline capacity (monoline capacity was also a constraint on CDO creation).

You might also look into the negative basis trade and how it led the dealers themselves to increasingly retain rather than place their AAA ABS CDO.

The Big Short is still an interesting book. It may not tell every aspect of the story but the story it tell is interesting and worth reading. Sounds like you wish it was a book that could inform policy in greater depth. Well, it’s another kind of book.

Please read Felix Salmon’s review of The Big Short. He and others like the Washington Post are hailing it as a definitive account. That means its views can/will become conventional wisdom and hence can influence policy, even if indirectly.

Thanks for the kind words about ECONNED. It was a Bataan death march getting it done.

Re the objection to Lewis, my main one is he goes to considerable lengths to paint the shorts in a favorable light (as someone who had done a lot of close reading of text, his devices are both obvious and frequent) and in particular, depict them (through Eisman) as friends of poor chump borrowers. In fact, they made things vastly worse. That’s why I regard his book as fundamentally misleading.

As for the “definitive account” and such, you can’t assume Lewis did not have a hand in that. All book PR is approved by the author. Lewis most certainly has his own publicist.

Despite your (in my opinion, overblown) exceptions, The Big Short is still “engaging story-telling and character depiction in combination with making a complex arena accessible to lay readers”. That has value for our largely uninformed mass-market. I’ve seen first-hand that the book can trigger the interest of those who have until now shown little interest in financial topics. That in my opinion is a good thing.

Attacking the popular with overblown criticism will probably be good for you. It got you a link from NYT and I’m sure it has increased your hits and probably helped the site’s Google ranking. Hopefully it’ll help sell more copies of ECONNED as well. Yet another value of The Big Short.

The point is that nothing changes until a number of the fools who created the entire mess are put away in the klink, nothing will change. We can write millions of words to one another and it will make no difference. Lock up a few people take away their yachts and planes and the system will improve.

This guy played a high stakes poker game against Wall Street and he won. He didn’t force the taxpayers to foot the bill. The US government chose to do so, and from what I remember, Yves has always agreed with that policy in the first place (even blaming on several occasions that Lehman didn’t get bailed out).

Lewis is notably silent on when Eisman (or whether) he exited the trade, and he also chronicles at some length how difficult it was for Burry and Cornwall Capital to close out their trades pre-Lehman. If he held it past the Lehman collapse, its value depended on bailouts. The counterparty on those CDS was for the most part dealers, PARTICULARLY since he set out to short Wing Chau, who was the outlet for Merrill’s CDOs.

I think Lewis’s point that this would have been different if the I Banks had remained partnerships is still valid despite all this nonsense about characters. If you don’t remember studying Black Sholes and at least thinking that something doesn’t seem quite right then you aren’t getting the big picture. We need securitization but we also need bankers that have a conscience.

I take your point – I read The Big Short thinking that these guys weren’t heroes but neither was GS.

If you and Lewis were each asked to list in ranked order the top 5 villains of the sub prime melt down — do you really think the lists would be that different?

I don’t remember Lewis ever saying his was a comprehensive analysis of the situation. I gather from the title of your book that you and Lewis agree with the rest of us that this was a bad situation created by bad actors and we should do what we can to avoid in the future.

Michael Lewis is going to appeal to a broader audience. His appeal is his outsider perspective. Your attempts to discredit him will likely not make a dent in his popularity. You could bring up your numbers though, and you gave me a reason to look up hagiography. So thank you for that.

I watched the CBS 60 minutes video of “Financial Collapse Part 1 with Lewis interviewed by Steve Croft.

Now I am not knowledgeble about the market and such and have really learned much by reading all of this.

I found it extremely suspicious that Lewis kept saying about the main Wall Streets actors …

“stupidity rather than corruption”

Firms “did not understand the machine they created”

“did not understand”

about Goldman Sachs political connections…
“it’s hard to know…there’s no proof”

That suspicion is what led me to the is great article.

But still there seem to be some underlying currents that need a little light.

The entire stock market system looks crooked and immoral to me and it did not become that way with the advent of the sub prime garbage.

There also seems in this story, and more and more news stories on the web, the underlying idea that capitalism is bad — absolutely no good. And I tend to agree with that. All the equity markets and paper instruments and speculation seem like sort of “greed gone crazy”. And there is no sense whatsover in all of this of patriotic national sovereignty. The markets and trading are international and what is best for one’s country and people plays no part in the “morally neutral” markets and trading games.

But I say morality plays a big role in all of this. Humans are making personal decisions that are killing large numbers of other humans.

I was raised as a Roman Catholic and I know that the Church is not in favor or capitalism, or socialism or libertarianism. I do not know what if any kind of economic system they do approve of. I do think the Church is inconsistent though and not much about nations maintaining their own national sovereignty as they seem to strongly support the United Nations.

I read Lewis’ book. It was fine, entertaining. I work in finance and understand the background of the crisis. I was not offended by the book at all.

What are mildly offensive, but even more amusing, are the comments to this article. I might have bought econned but for the endless posts that Yves Smith and probably her agent and publisher have posted in the guise of comments from sycophantic readers.

Yves, it’s pretty transparent. When virtually all of the comments are about how “brilliant” Yves Smith is and how much better her book is than Lewis’, it’s kinda obvious. Esp when your book is competing on the shelves of Borders (but not really – I’ve never seen your book).

Maybe I’ll read econned. But settle down on the endless shameless plugging.

I’m currently reading both The Big Short and Econned. I started with Econned first, but after a few chapters I had to take a break from the muckraking. It’s a fine book and I would recommend it to anyone who has taken finance or global econ in college or b-school.

In the next 6 hours though, I got through 3/4 of TBS before I finally forced myself to put it down. Lewis is a master study of character and viewpoint and how they drove the decisions behind the mortgage meltdown. Talking about the widows, pensioners, and taxpayers who got screwed in the end was out of the book’s scope. I don’t think the book’s heroes deserve the sort of criticism you’re giving them. At several points, the shorts were vulnerable to the investment banks stalling and not paying out until those banks decided to get in on the same trade.

NPR had a well made feature on American Life today about Magnetar and their method to worsen the crisis and profit from it, underhttp://www.thisamericanlife.org/

They also asked if the CDO managers had violated their fiduciary duty towards the investors but not mentioning Magnetar’s investment behavior to other clients, but said it would be difficult to proof.

————————————-
Description:
Inside Job
Broadcast: Apr-9-10
For seven months a team of investigative journalists from the group ProPublica has been looking into a story for us, the inside story of one company, one small group of people, who made hundreds of millions of dollars for themselves while worsening the financial crisis for the rest of us. This and other stories of inside jobs.

I don’t understand your thesis about how the shorts created/abetted/worsened the bubble in these mortgages. Their actions created more synthetic supply not demand. By their actions it wasn’t necessary for a bank to go out and issue new crap loans, because the shorts buying CDS essentially created securities that were their twins. The people creating the CDOs certainly created demand and lowered interest rates as did the chumps buying the CDOs, but by any calculation I can do the people shorting this market would have had exactly the opposite effect.
Thanks,
Anthony

If you merely had a CDS buyer and a CDS seller, each taking the exposure on a contract by contract basis, you would be correct, the CDS protection buyers would drive up CDS spreads, and via arbitrage, also drive up spreads for the worst credits (the ones they were keen to short).

Empirically, that is the opposite of what happened. In 2005, cash buyers were not willing to buy the riskier tranches of subprime RMBS. That should have led to a rise in interest rates and stanched demand. But instead, even as the Fed was increasing rates, even as prime mortgages was falling off, subprime demand not only continued to be robust, but demand for the dodgiest mortgages increased, the exact opposite of what you’d expect in a rising rate environment, when spreads for the riskiest credits usually widen first.

The use of CDOs (which were as both our and Lewis’s account describe) masked BBB risk as AAA risk, bringing new protection sellers to the table. And as the Goldman/Paulson and Magnetar trades suggest, the shorts knew full well the use of a CDO was the mechanism that enabled them to obtain protection at artificially low prices.

Your logic matches my logic for the most part. I still come up with the shorts not being responsible for the observed effect. I agree that empirically CDO yields declined, but I’m missing your causality. I’d argue that your assertion about correlation traders causing this makes sense, but the correlation traders were the ones buying the relatively high yielding (junk) CDOs and funding using repos on legit AAA debt. Please walk me through the mechanism that caused the synthetic CDO shorts to increase demand/lower CDO yields as you assert. Furthermore, I agree with your third paragraph, but this evidence seems damning for the firms creating cash CDOs not the synthetic shorts that you blame.

Thanks for taking the time to respond, I’m sure that there’s some aspect of this that one of us is missing. I’d really like to figure out what it is.